My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Friday, February 17, 2017

My Snap Story: Valuing Snap ahead of it's IPO!

Five years ago, when my daughter asked me whether I had Snapchat installed on my phone, my response was “Snapwhat?". In the weeks following, she managed to convince the rest of us in the family to install the app on our phones, if for no other reason than to admire her photo taking skills. At the time, what made the app stand out was the impermanence of the photos that you shared with your circle, since they disappeared a few seconds after you viewed them, a big selling point for sharers lacking impulse control. In 2013, when Facebook offered $3 billion to buy Snap, it was a clear indication that the new company was making inroads in the social media market, especially with teenagers. When Evan Spiegel and Bobby Murphy, Snap's founders, turned down the offer, I am sure that there were many who viewed them as insane, since Snap had trouble attracting advertisers to its platform and little in revenues, at the time. After all, what advertiser wants advertisements to disappear seconds after you see them? Needless to say, as the IPO nears and it looks like the company will be priced at $20 billion or more, it looks like Snap's founders will have the last laugh!

Snap: A Camera Company?

The Snap prospectus leads off with these words: Snap Inc. is a camera company. But is it? When I think of camera companies, I think of Eastman Kodak, Polaroid and the Japanese players (Fuji, Pentax) as the old guard, under assault as they face disruption from smartphone cameras, and companies like GoPro as the new entrants in the space, struggling to convert sales to profits. I don't think that this is the company that Snap aspires to keep and since it does not sell cameras or make money on photos, it is difficult to see it fitting in. If you define business in terms of how a company plans to make money, I would argue that Snap is an advertising business, albeit one in the online or digital space. I do know that Snap has hardware that it is selling in the form of Spectacles, but at least at the moment, the glasses seem to be designed to get users to stay in the Snap ecosystem for longer and see more ads.

So, why does Snap present itself as a camera company? I think that the answer lies in the social media business, as it stands today, and how entrants either carve a niche for themselves or get labeled as me-too companies. Facebook, notwithstanding the additions of Instagram and WhatsApp, is fundamentally a platform for posting to friends, LinkedIn is a your place for business networking, Twitter is where you go if you want to reach lots of people quickly with short messages or news and Snap, as I see it, is trying to position itself as the social media platform built around visual images (photos and video). The question of whether this positioning will work, especially given Facebook's investments in Instagram and new entrants into the market, is central to what value you will attach to Snap.

The Online Advertising Business

If you classify Snap as an online advertising company, the next step in the process becomes simple: identifying the total market for online advertising, the players in that market and what place you would give Snap in this market. Let’s start with some basic data on the online advertising market.

It is a big market, growing and tilting to mobile: The digital online advertising market is growing, mostly at the expense of conventional advertising (newspapers, TV, billboards) etc. You can see this in the graph below, where I plot total advertising expenditures each year and the portion that is online advertising for 2011-2016 and with forecasted values for 2017-2019. In 2016, the digital ad market generated revenues globally of close to $200 billion, up from about $100 billion in 2012, and these revenues are expected to climb to over $300 billion in 2020. As a percent of total ad spending of $660 billion in 2016, digital advertising accounted for about 30% and is expected to account for almost 40% in 2020. The mobile portion of digital advertising is also increasing, claiming from about 3.45% of digital ad spending to about half of all ad spending in 2016, with the expectation that it will account for almost two thirds of all digital advertising in 2020.

Sources: Multiple

With two giant players: There are two dominant players in the market, Google with its search engine and Facebook with its social media platforms. These two companies together control about 43% of the overall market, as you can see in this pie chart:

If you are a small player in the US market, the even scarier statistic is that these two giants are taking an even larger percentage of new online advertising than their historical share. In 2015 and 2016, for instance, Google and Facebook accounted for about two-thirds of the growth in the digital ad market. Put simply, these two companies are big and getting bigger and relentlessly aggressive about going after smaller competitors.

In a post in August 2015, I argued that the size of the online advertising market may be leading both entrepreneurs and investors to over estimate their chances of both growing revenues and delivering profits, leading to what I termed the big market delusion. As Snap adds its name to the mix, that concern only gets larger, since it is not clear that the market is big enough or growing fast enough to accommodate the expectations of investors in the many companies in the space.

Snap: Possible Story Lines

To value a young company, especially one like Snap, you have to have a vision for what you see as success for the company, since there is little history for you to draw on and there are so many divergent paths that the company can follow, as it ages. That might sound really subjective, but without it, you are at the mercy of historical data that is both scarce and noisy or of metrics (like users and user intensity) that can lead you to misleading valuations.

That is, of course, another shameless plug for my book on narrative and numbers, and if you have heard it before or have no interest in reading it, I apologize and let's go on. To get perspective on Snap, let’s start by comparing it to three social media companies, Facebook, Twitter and LinkedIn and to Google, the old player in the mix, at the time of their initial public offerings. The table below summarizes key numbers at the time of their IPOs, with a comparison to Snap's numbers.

At the time of its IPO, Snap has less revenues than any of its peer group, other than LinkedIn, and is losing more money than any of them. Before you view this is a death knell for Snap, one reason for Snap’s big losses is that unlike its competitors, Snap pays for server space as it acquires new users, thus pushing up its operating expenses (and pushing down capital investment in servers). There is one other dimension where Snap measures up more favorably against at least two of the other companies: its users are spending more time on its platform that they were either on Twitter and LinkedIn and it ranks second only to Facebook on this dimension.

The more important question that you face with Snap, then, is which of these companies it will emulate in its post IPO year. The table below provides the contrast rather by looking at the years since the IPO for each company.

Google and Facebook stand out as success stories, Google because it has maintained high revenue growth for almost a decade with very good profit margins and Facebook doing even better on both dimensions (higher growth in the earlier years and even higher margins). The least successful company in this mix is Twitter which has seen revenue growth that has trailed expectations and has been unable to unlock the secret to monetizing its user base, as it continues to post losses. Linkedin falls in the middle, with solid revenue growth for its first four years and some profits, but its margins are not only small but showed no signs of improvement from year to year. Now that it has been acquired by Microsoft, it will be interesting to see if the combination translates into better growth and margins.

My Snap Story & Valuation

To value Snap, I built my story by looking at what its founders have said about the company, how its structured and the strengths and weaknesses of its platform, at least as I see them. As a consequence, here is what I see the company evolving.

Snap will remain focused on online advertising: I believe that Snap's revenues will continue to come entirely or predominantly from advertising. Thus, the payoff to Spectacles or any other hardware offered by the company will be in more advertising for the company.

Marketing to younger, tech-savvy users: Snap's platform, with its emphasis on the visual and the temporary, will remain more attractive to younger users. Rather than dilute the platform to go after the bigger market, Snap will create offerings to increase its hold on the youth segment of the market.

Source: The Economist

With an emphasis on user intensity over users: Snap's prospectus and public utterances by its founders emphasize user intensity more than the number of users, in contrast to earlier social media companies. This emphasis is backed up by the company's actions: the new features that it has added, like stories and geofilters, seem designed more to increase how much time users spend in the app than on getting new users. Some of that shift in emphasis reflects changes in how investors perceive social media companies, perhaps sobered by Twitter's failure to convert large user numbers into profits, and some of it is in Snap's business model, where adding users is not costless (since it has to pay for server space).

These assumptions, in turn, drive my forecasts of revenues, margins and reinvestment. In my story, I don't see Snap reaching revenues of the magnitude delivered by Google and Facebook, the two big market players in the game, settling instead for smaller revenues. If Snap is able to hold on to its target market (young, tech savvy and visually inclined) and keep its users engaged, I think Snap has a chance of delivering high operating profit margins, perhaps not of the magnitude of Facebook today (45% margin) but close to that of Google (25% margin). Finally, its reinvestment will take the form of acquisition of technology and server space to sustain its user base, but by not trying to be the next Facebook, it will not have to over reach. Is there substantial risk that the story may not work out the way I expect it to? Of course! While I will give Snap a cost of capital of close to 10% (and in the 85th percentile of US companies), reflective of its online advertising business, I will also assume that there remains a non-trivial chance (10%) that the company will not make it. The picture below captures my story and the valuation inputs that emerge from it:

To complete the valuation, there are two other details that relate to the IPO.

Share count: For an IPO, share count can be tricky, and especially so for a young tech company with multiple claims on equity in the form of options and restricted stock issues. Looking through the prospectus and adding up the shares outstanding on all three classes of shares, including shares set aside for restricted stock issues and assorted purposes, I get a total of 1,243.10 million shares outstanding in the company. In addition, I estimate that there are 44.90 million options outstanding in the company, with an average exercise price of $2.33 and an assumed maturity of 3 years.

IPO Proceeds: This is a factor specific to IPOs and reflect the fact that cash is raised by the company on the offering date. If that cash is retained by the company, it adds to the value of the company (a version of post-money valuation). In the case of Snap, it is estimated that roughly $3 billion in cash from the offering that will be held by the company, to cover costs like the $2 billion that Snap has contracted to pay Google for cloud space for the next five years.

Allowing for the uncertainty inherent in my estimates, I also computed probability distribution for three key inputs, revenue growth, operating margin and cost of capital, and my value for Snap's equity is in the distribution below:

Assuming that my share count is right, my value per share is about $11 per share. As you can see though, as is the case with almost any young company where the narrative can take you in other directions, there is a wide range around my expectations, with the lowest value being less than zero and the highest value pushing above $66 billion ($50/share). The median value is $13.3 billion and the average is $14.9 billion; one attractive feature to investors is that there is potential for breakout values (optionality) that exceed $30 billion.

The numbers at the high end of the spectrum reflect a pathway for Snap that I call the Facebook Light story, where it emerges as a serious contender to Facebook in terms of time that users spend on its platform, but with a smaller user base. That leads to revenues of close to $25 billion by 2027, an operating margin of 40% for the company and a value for the equity of $48 billion.

The numbers at the other end of the spectrum capture a darker version of the story, that I label Twitter Redux, where user growth slows, user intensity comes under stress and advertising lags expectations. In this variant, Snap will have trouble getting pushing revenue growth past 35%, settling for about $4 billion in revenues in 2027, is able to improve its margin to only 10% in steady state, yielding a value of equity of about $4 billion.

As I learned the painful way with my Twitter experiences, the quality of the management at a young company can play a significant role in how the story evolves. I am impressed with both the poise that Snap's founders are showing in their public appearances and the story that they are telling about the company, though I am disappointed that they have followed the Google/Facebook path and consolidated control in the company by creating shares with different voting rights. I know that is in keeping with the tech sector's founder worship and paranoia about "short term" investors , but my advice, unsolicited and perhaps unwelcome, is that Snap's founders should trust markets more. After all, if you welcome me to invest me in your company and I do, you should want my input as well, right?

The Pricing Contrast
As I finish this post, I notice this news story from this morning that suggests that bankers have arrived at an offering price, yielding a pricing for the company of $18.5 billion to $21.5 billion for the company, about $4 billion above my estimate. So, how do I explain the difference between my valuation and this pricing? First, I have never felt the urge to explain what other people pay for a stock, since it is a free market and investors make their own judgments. Second, and this is keeping with a theme that I have promoted repeatedly in my posts, bankers don't value companies; they price them! If you are missing the contrast between value and price, you are welcome to read this piece that I have on the topic, but simply put, your job in pricing is not to assess the fair value of a company but to decide what investors will pay for the company today. The former is determined by cash flows, growth and risk, i.e., the inputs that I have grappled with in my story and valuation, and the latter is set by what investors are paying for other companies in the space. After all, if investors are willing to attach a pricing of $12 billion to Twitter, a social media company seeming incapable of translating potential to profits, and Microsoft is paying $26 billion for LinkedIn, another social media company whose grasp exceeded its reach, why should they not pay $20 billion for Snap, a company with vastly greater user engagement than either LinkedIn or Twitter? With pricing, everything is relative and Snap may be a bargain at $20 billion to a trader.

Stock Market,Do you read posts before you comment on them? The entire post is about Snap's business model and story. I don't think I mention the spreadsheet more than once and only in passing. And if you restricted stock market commenting to just great investors, we would be looking at not much commenting, right?

Thanks for the post Aswath! Always a pleasure reading your take on IPO's.

This question relates less to the value of Snap and more toward pricing. I'm curious as to how the dozens of technology etf's will influence share price and activity (volume). Considering most funds are rule based, will not thousands of both passive and active funds be required to 'snap up' the company by virtue of its size, industry, NYSE listing etc.? Will this buying pressure outweigh all selling power from a potential misprice? Additionally, when will the S&P 500 selection committee will include the company in the index?

Thanks for the great post. I am not an NYU student and I still love these and read every one.

Can you clarify how you calculate the share count since this is rather confusing?

News sites report that: Snap Inc, the owner of ephemeral messaging app Snapchat, sees its upcoming initial public offering (IPO) priced at between $14 and $16 per share, according to a regulatory filing released Thursday.

This would value the company at between $19.5 billion to $22.2 billion.

But using your share count of 1,243 and the $14-$16 price, I only get to 17.4Bn and 19.8Bn

Great analysis as usual. Would have loved some more details on a few things: 1) whether the user segment (15 -24 predominantly) is attractive to advertisers. They don't have much spending power. Tumbler was similar and had hard time monetizing that user base. 2) Competition: Instagram has done a great job using the photo/video story of Snap and marketing to a wider user base. 3) Expansion: Snap is almost non-existent outside US.I was surprised how popular Instagram is with teenagers as well as all ages in India

This range forecast is a brilliant idea. I've never seen it before. It makes the IPO pricing sensible (from the perspective of the company and the bankers). I think they will get filled at that level because there will be true believers who think it's worth more. I'll take a swing at it after it lists if it tanks into the $8-10 billion range. Thanks Professor.

Professor, I am sorry if I had hurt you with my opinion/comments. I went though whole post and focus is more on numbers and estimates - that kind of approach may be right for normal companies but not for this kind of silly companies which are just riding the wave.

Share count questions.I used the prospectus and it does include shares that will be outstanding after the offering. That said, there is some fuzziness in the numbers especially in the shares set aside to cover options and RSUs for 2017. The shares set aside for options are dealt with separately in the option section of the valuation. I counted all of the other shares that are lined up, except for one offering that is set aside to replace shares that may be used to cover existing shares that will be issued on RSUs. On the young and fickle customer baseIt is true that Snap's target audience of young over-sharers has good points (they account for a disproportionate amount of online time) and bad ones (they often don't have incomes and are subject to fads). That will be one of the trickiest aspects of Snap's evolution and something worth watching.Steven,The 10% is just my estimate and here is what I use. For start-ups with potential and no product, I use 50-60%. For young, private companies that are dependent on VC capital, I use 20-30%. As a company goes public, I start lowering that number because you have more access to capital. Once they start making money, I will move it to 0%.Tobias,Thank you. Simulations and probability distributions were out of our reach (in terms of access and cost) thirty years ago. I don't know why we do not use these tools more in analysis.Stock Market,I don't have a thin skin. So, I did not take your comment personally. My only reason for responding was that the comment would have been better directed at a spreadsheet-based valuation, which this one is not. And I will cheerfully admit that while my family is happy with me as a portfolio manager (they cannot fire me easily), I have not made billions!

I do not think any of Twitters issues are due to management, and doubt that even if one thinks that Snap management is more capable, that it will be able to support for any period of time a "pricing" at the level of that desired by the underwriters. Here's why: Advertisers have not seen sufficient reason to advertise on Twitter, and while digital spend for advertisers has increased, advertisers have become more circumspect in where they place ad dollars. FB is an example: Advertisers are demanding better metrics of measurement to see the effectiveness of the dollars going to FB. So, with advertisers being more reluctant to just spread the ad dollars, and instead desiring meaningful targeting, it is hard to see material ad spend heading to Snap given its demographics.Before seeing this post I pegged the IPO "pricing" as no more than Twitters current market price and would not be surprised if it trades down if the underwriters achieve their lofty IPO price.

Thank you for making these available to the large public. I love your forward thinking approach.

To add to snap's story, I believe that the psychological understanding of the user base is key to understanding the value and potential of snap. The use of the snap filters such as the "butterfly crown" to post, for example, selfies on instagram is not a gimmick for these users. I personally have a hard time understanding the appeal but there is definitely a large loyal user base that use these as a lifestyle. So from that perspective snap being labeled a camera company makes sense; these filters are not a gimmick for the users and more of a way to represent their reality (or the reality they wish to have).

Professor,Snapchat is the same thing as its older cousin in China WeChat. WeChat has a profound impact on China, virtually a new platform for doing almost everything. If snap could be nearly as successful in US, then the potential is huge.

"After all, if you welcome me to invest me in your company and I do, you should want my input as well, right?"

Very utopian. Really the purpose of these IPOs is for company founders, employees, and early investors to cash out, not to want public shareholder input. The purpose of public markets is to raise capital but these internet companies need very little capital, they could stay private forever.

Thank you very much for your post. My question is more general than directly related to this post. It is about the way you calculate the sales-to-capital ratio. I have noticed that sometimes is computed as sales to book value of invested capital AND sometimes as a change in sales over reinvestment (with the latter item being net capex AND net WCInv). My first question, is which one of these is better to use and when? My personal guess is that the one dealing with BV, shows the sales/cap ratio of the existing assets in place, whereas the latter of the marginal one, if my wording is correct.The second question is about the non-cash WC investment. There are two ways one may calculate it using either a balance sheet OR a cash flow statement. However, I notice it very often that there are differences (sometimes staggering) between the two. As such, which one approach would you personally recommend and why?

I have a question on how you computed a sales-to-capital ratio of 2 for Facebook, which you apply in your valuation of Snap. It just happened so that a couple of days ago I computed the same ratio for Facebook and my number was about 1.0. My educated guess is that you may have deducted goodwill from the book value of invested capital. I would appreciate if you could clarify this point.

Just one minor comment: A fair assumption is that per-user the capital expenses (in terms of server cost) will continue to fall over time primarily because computer hardware costs keep falling (a GB today is far cheaper than a GB a decade back, same for bandwidth). So I think that snap is doing the right thing by outsourcing the hardware/servers and focusing on growth instead. If it becomes profitable it always has the opportunity to build out it's own data center, and that capex will also help reduce it's taxes. If user growth slows down, it just needs to pay less to the server providers today.

To cut a long story short, I think snap has an asset light model, which is very smart and flexible. It also has the option to reinvest (eventual) profits to save on hosting costs eventually. This fact may boost the valuation to some extent at least.

Thank you for the informative post. I am intrigued by your way to use probability distribution to estimate the key parameters. Can you write more on the topic on how to create probability distribution in excel please?

I tend to visualize many outcomes in the market as being bimodal or even binary. For example, I find it quite unlikely that Snap achieves an average outcome - either it successfully converts users to revenue, or it doesn't.

At a theoretical level, normal(ish) distributions arise from the Central Limit Theorem as the consequence of the interaction of many independent random samples.

With this in mind, a company that participates in many diversified and independent sources of revenue will have well-behaved outcomes. A company like Snap whose success depends almost entirely on whether the business model is viable has nothing to pull it towards an average outcome.

At the extreme, certain situations (FDA approvals, election results) consist of only a single event and the distribution of outcomes should just be two different prices, weighted by their probability of occurring.

In this model your valuation is controlled almost entirely by the probability of success/failure, which seems nearly impossible to estimate without considerable domain knowledge.

Why should management automatically welcome my input because I have decided to invest with them? As a supplier of capital, it's not obvious why my input should be more valuable than that of a supplier of labour, say. Furthermore, one might turn the argument around: if I've decided to back a management team by investing behind them, why wouldn't I trust them to take decisions?

My own biases on this subject are clear: I don't like management teams to have unfettered control of a company, and in one case my firm has sued a portfolio company to ensure that shareholders would be treated better than their historical experience. We pay close attention to what management are able to do or are constrained from doing in our investment processes, but if we dislike or don't trust management, shareholder protection is often of little comfort.

Having said that, the risk of ceding influence or control to others can presumably be valued, no? And if so, should't the risk be reflected in the share price? One would certainly expect to see investor protections (or lack thereof) to be incorporated in bond prices, and that principle should hold across the capital structure. Might one expect to see one or more of a higher discount rate, a wider range of valuation outcomes, or a longer (left-hand) tail in instances where shareholders cede more (or all) control to managers?

Do you think it's better to capitalize the fee that snapchat pays google for server space? I feel it's like rent if snapchat is a retail company. In this case, should we capitalize it as a operating lease?

Professor many thanks for another very interesting piece of analysis.I was intrigued by your probability distribution analysis and wanted to ask if you upload the xcl files of that analysis too?Is it correct to assume that you probability analysis was suitable in this case of a young company with unpredictable performance, while for mature companies the same analysis would not be warranted?

Many thanks and looking forward to new your new posts, particularly on Valeant.

Thank you for this article Professor.One question about the 3Bn proceeds from the IPO. They are needed for the plan to be executed, so why add them to the value of equity? If the company does not manage to raise money, the financial trajectory of the company, and its cash flows, will not be the same. In other words, the result from a DCF exercise shouldn't it always be a post-money valuation? If not, what am I missing?Many thanks in advance for your anwser!Alex

I like to perform this kind of valuations (modeling and describing it) just as you do. I have a question: on average, how much do you spend on doing these analysis? I want to get a feeling of how "efficient" I am on doing this.

Thanks for the great post. Just a follow up musing - I am too old to be a snapchat users, but it seems the USP is ephemeral nature of the media share. I see two issues - first is technical. It is technically possible to circumvent this feature by users if they really want to. There are already some apps available for screen capture. So what is the risk that some smart apps suddenly becomes popular and kills the credibility of the app - effectively adding a large left tail to the distribution. Secondly, if you assume social media with unique USPs like this works only on cohort (younger generation switch to something even more exciting) and if you app's basic appeal is to young people lacking self-control, how does that translate to future revenues. This cohort may not be the most successful (in terms of disposable income) lot of their generation.

Very nice article, professor! I am a bit curious if you don't mind: Is your motivation to value Snap stemming from your interest in valuing businesses in general, or were you considering investing in Snap prior to your analysis?

Do you think the voting share structure of Snap at this point is worth discounting or adding a premium? Twitter's founding leadership clearly was more fractured than SNAP, FB, or GOOG, thus they could not mimic the share structure of those peers and IPO successfully. Do you think you would almost price in a premium for the leadership structure at SNAP? (of course this could be dependent on your feelings of the leadership of the company).

SNAP mentions Evan Spiegal 10 times in Risk Factors - FB mentions Zuck 5, and TWTR had no mentions of Dick Costolo - interesting to see which is still in control...

Do you think the voting share structure of Snap at this point is worth discounting or adding a premium? Twitter's founding leadership clearly was more fractured than SNAP, FB, or GOOG, thus they could not mimic the share structure of those peers and IPO successfully. Do you think you would almost price in a premium for the leadership structure at SNAP? (of course this could be dependent on your feelings of the leadership of the company).

SNAP mentions Evan Spiegal 10 times in Risk Factors - FB mentions Zuck 5, and TWTR had no mentions of Dick Costolo - interesting to see which is still in control...

Thank you for the insightful post and for sharing your thoughts on this very interesting IPO. Thanks for mentioning your book as well ;) I see that it's already got great reviews. I'm looking forward to reading it!

Regarding what appears to be a Monte Carlo simulation of equity value, I'm extremely intrigued and would greatly appreciate further details, please? I would love to know what platform you used to generate, and if you're possibly open to sharing your code, please?

" remain more attractive to younger users."This is a very important assumption because it limits the potential growth. You might have made the same assumption about Facebook circa 2009 since young people were their main focus but they managed to become mainstream. Actually every successful consumer tech company walked the same route: young early adopters to Gen X to Boomers. Assuming that Snap will not do this same thing is actually a pretty big assumption that is not supported by the history of other successful consumer tech companies.

P.s. to everyone who asked about the equity value simulation : Professor Damodaran happened to mention in his subsequent posting / video on Valeant that he's using Oracle's "Crystal Ball" software, which is an Excel Add-In.

Crystal Ball looks to be very handy, but isn't cheap at $1K. Here's an old YouTube demo which gives a good basic overview:

SNAP has seen a big drop due to IPO lockup expiry concerns, and huge amount of shares are going to be available. The lockup expiry is going to happen from July-Aug end. 1200M shares are going to be available.

As all IPOs does during lockup expiration (FB dropped huge too), there is a huge downside during such times. I would think that SNAP can hit your original average valuation of $11. Would you be a buyer at those prices, and let us know your take on SNAP taking into account the stock dilution.